EXPECT & PLAN For A Major Stock Market Correction In the Coming Weeks/Months – Here’s Why & How

The S&P 500 is now up over 180% since troughing in March 2009 and it has been almost 3 years since the market experienced a 10% correction. Historically, market corrections happen approximately every 2 years on average. [As such,] we think that this rally is getting very long in the tooth and we wouldn’t be surprised if we have a healthy pullback in the coming weeks or months.

The above are edited excerpts from an article byParsimony Investment Research (parsimonyresearch.com/) entitled Correction 2014: Are You Prepared?.

The following article is presented by Lorimer Wilson, editor ofwww.munKNEE.com (Your Key to Making Money!), www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and the FREEMarket Intelligence Report newsletter (sample here; register here) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.

Further edited excerpts are as follows:

As shown in the chart below, each of the major rallies over the past 15 years have been followed by a significant correction. This roller coaster has certainly taken a toll on most investors and many are just recently getting comfortable with the idea of holding stocks in their portfolio again.

Now, however, investors are feeling the full impact of fear and greed. On one hand, many investors fear missing out on future gains if this rally continues (especially if they missed out on most of the current rally). On the other hand, greed certainly rears its ugly head when investors are sitting on big gains and they don’t want the fun to end.

Is a Correction Coming In 2014?

…A correction is a stock market decline of 10% or more and we haven’t seen one in…almost 3 years… Historically, market corrections happen approximately every 2 years on average, so the million dollar question is…will we finally see one in 2014?

Even though the correction bandwagon seems to get louder every day, there have been much larger correction droughts historically.

Since 1928, there have been 5 periods with correction gaps that were longer than the one that we are currently in.

The record drought was 1,767 market days (from October 1990 to October 1997).

The second largest drought was 1,153 days (from March 2003 to October 2007)…

Basically, this tells us that a market correction won’t necessarily be a self-fulfilling prophecy and that we shouldn’t be surprised if stocks continues to chug along in 2014.

Current Valuations

…The S&P 500 is currently trading around 19 times trailing earnings (vs. an average multiple of 15.5x since 1871)! Again, history is littered with examples where above average P/E multiples were sustained for prolonged periods of time. In fact, during the last bull run (2003-2007), stocks spent more than a year trading north of 20 times earnings.

Bottom line is that none of us know when (or if) a correction will occur in 2014 and the best we can do is stick to our investment plan. That said, we think that this rally is getting very long in the tooth and we wouldn’t be surprised if we have a healthy pullback in the coming weeks or months.

For the most part this rally has been Fed-induced (through low rates and easy monetary policy) and economic fundamentals may not be able to support current stock prices. We definitely think that stocks will finish 2014 on a positive note, but we believe that the next 3 months will remain volatile….

Since we won’t be able to time the market top, we feel that now is as good of a time as any to start implementing a short-term “hedge” for your portfolio.

Why Hedge?

First and foremost, it’s important to remember that market corrections happen and, that said, investors need to EXPECT, and more importantly, PLAN for major corrections.

Investors often forget that a significant market correction can wreak havoc on even the highest-quality, dividend-paying stocks. It’s actually difficult to find a dividend stock that didn’t experience a decline of at least 30% during the 2008 recession.

Below are the 2008 maximum drawdowns for some widely held “defensive” dividend stocks:

Coca-Cola (KO): -40.6%

Johnson & Johnson (JNJ): -34.4%

Verizon Communications (VZ): -42.5%

A portfolio hedge could have reduced these losses significantly… without having to sell your stock or give up your dividend. Investors can plan for a market correction by taking the necessary steps to hedge their portfolio. In our opinion, a protective put hedge strategy is the easiest and most cost-effective way to hedge a portfolio.

Market Volatility

The CBOE Market Volatility Index (VIX) is a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30-day period.

As shown in the graph above, the VIX closed at 11.68 yesterday, which is very close to all-time lows. In theory, when expectations of future implied volatility are so low, it is a contrarian indicator that investors are overly optimistic about the future. In other words, when the VIX is low, there isn’t enough “fear” in the market. Historically, market corrections tend to spawn when implied volatility (or fear) is low. (Note: iPath has an ETN that tracks short-term VIX futures, iPath S&P 500 VIX (VXX), which is also a good proxy for future implied volatility.)

Protective Put Strategy Overview

That said, this is also the best time for an investor to purchase protective puts because the cost of protection is extremely low.Implied volatility is one of the main variables in option pricing models and as implied volatility declines, so does the price of the option.

The main purpose of hedging your dividend portfolio is to limit your downside market exposure (i.e., protect your capital base), while keeping your dividend income intact. As we said above, we believe that purchasing a protective put is the easiest (and most cost effective) way to hedge your portfolio.

We like to use options on the S&P 500 ETF (SPY) for our protective put strategy. Remember that we are only trying to “hedge” the general market exposure in our portfolio and the S&P 500 is a great proxy for the general market. In addition, SPY options are extremely liquid, which makes them very easy to trade.

Conclusion

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. A hedge is essentially an insurance policy for your portfolio and whether or not you decide to hedge your own portfolio will depend on your specific market outlook and risk tolerance.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

Greed may have been good for Gordon Gekko. but in the investment world it rarely is. As Warren Buffett is famous for saying “…be fearful when others are greedy and greedy when others are fearful” [and now is such a time]…to start showing some level of fear here in the face of extreme greed by the crowd. The crowd can be right for a long time, but they are rarely right at extremes. While this time may be different, the probabilities suggest that at the very least it will be a more difficult environment for equities going forward.

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